Chapter 13: Making Monetary Policy
J. Bradford DeLong
--First Draft-January 11, 1999: 2,259 words
The
13-1: Limits of stabilization policy
13-1-1: Policy recognition and formulation lags
13-1-2: Implementation lags
13-1-3: Slippage: the term structure
13-1-4: The limits of stabilization policy
13-2: Monetarism
13-2-1: The Tinbergen framework...
13-2-2: Money as a leading indicator of output
13-2-3: Money certainly a better indicator of policy stance than nominal interest rates
13-2-4: The monetarist program: look at the money stock alone, and reform the banking
system so that money is an even better leading indicator of output
13-2-5: Which monetary aggregate? Goodhart's law
13-2-6: Instability in money demand: what is the future of the money demand function?
13-3: Credibility and dynamic inconsistency
13-3-1: The advantages of unexpected inflation
13-3-2: Dynamic inconsistency
13-3-3: Ways of solving the dynamic inconsistency problem
13-4: Politics and central bank independence
13-4-1: Arthur Burns's dilemma
13-4-2: Political pressure for more expansionary policies
13-4-3: Benefits from credibility longer than a single administration can promise
13-4-4: Central bank independence: a good thing?
Topic 10
Monetary Policy
10.1
Making Monetary Policy
The central bank is the institution that conducts monetary policy, which is the
principal tool used today to try to keep the economy stabilized. In the United
States, the central bank is the Federal Reserve system, and it has the principal
responsibility for trying to avoid the extremes of recession and rising inflation
and to keep the economy in the narrow range of steady growth and stable
inflation. This is probably the correct institutional division of labor. Over the past
50 years monetary policy has proven itself to be faster-acting and more reliable
than fiscal policy in countering the shocks to aggregate demand that periodically
affect the economy.
When Congress tries to stabilize the economy by changing taxes and spending-that is, making fiscal policy--the best outcome is that its policies have their effects
in about two years. (By contrast, fiscal automatic stabilizers--fiscal policy that
does not need Congress--take effect within nine months, as we saw in Topic 9.)
Because monetary policy works more rapidly, the Federal Reserve's role in
macroeconomic management has increased.
Monetary policy also takes considerable time to affect the economy: more than a
year. And there are some significant lags in monetary policy--recognition lags,
formulation lags, and implementation lags--just as there are for fiscal policy. The
Federal Reserve's ability to react quickly to changes in circumstances is limited
by the fact that its policy making body, the Federal Reserve Open Market
Committee (FOMC) is, as its name implies, a committee. Committees that
operate by consensus can be slow to move because everyone on them needs to be
more or less satisfied in order to shift away from the status quo. So the
government has only a very limited and very imperfect ability to fine-tune the
economy. Consider that the typical recessions in the United States since World
War II have lasted for eighteen months or less, and recognize that by the time the
Federal Reserve has recognized that a recession has begun it is too late for
changes in monetary policy to boost national product before the recession comes
to an end.
Today the Federal Reserve focuses on controlling interest rates. In the past it has
occasionally let interest rates be more volatile and focused on controlling the rate
of growth of the money supply--also called the money stock--which is the
economy's total supply of liquid assets. Should the Federal Reserve target real
interest rates--try to keep stable, perhaps allowing them to climb when inflation
threatens and fall in recession? Or should it focus on keeping the money supply
growing smoothly? Two decades of experience have taught us that it is better for
the Federal Reserve to have as its monetary target the level of interest rates than
the growth of the money supply. The relationship between the money supply
and the level of national product is growing less reliable over time, as
technological and institutional changes change the financial system.
10.2
Central Bank Credibility
No matter what the agreed-on and anticipated course of monetary policy, there
is a temptation for the central bank to pursue a more expansionary monetary
policy: more expansionary policy raises national product, reduces the
unemployment rate, and--in the short run at least--has little impact on inflation.
Central banks benefit if workers, firms, and investors all believe that future
inflation will be low. But why does anyone outside ever believe that a central
bank will aim for low inflation? And given their goals, what makes central banks
into inflation-fighters?
This conflict between central bankers' long-term goals and the policies that are
best for the short run can be resolved only if the central bank as an institution
maintains credibility. Belief that the central bank will carry out the anti-inflation
policies it proclaims is the first step toward a monetary policy that keeps
inflation low. Successful monetary policy is only possible where the makers of
monetary policy have enough credibility to make those outside think they will
focus first on controlling inflation, and only where the institution is stable
enough for such commitments to have a long time span. But most important is
the credibility that comes from a history of past successful control of inflation.
Without such credibility, aiming at low inflation will be a catastrophic failure. It
will lead to situations in which inflation will be high and recessions will be deep.
Thus, central bankers value very highly their institutional reputation for doing
what they say will and keeping inflation low. They are very careful to guard
against any words or actions that might even hint that they lack commitment to
maintaining low inflation. Once central banker credibility erodes, it is very
difficult to restore--and very painful to keep inflation low while that credibility is
restored.
10.3
Financial Panics
For nearly four hundred years market economies have undergone financial
crises--episodes when the prices of stocks or of other assets crash, everyone tries
to move their wealth into safer forms at once, and the consequent panic among
investors can lead to a prolonged and serious depression. Managing such
financial crises has been one of the responsibilities of monetary policy makers for
more than a century and a half.
A financial panic--like the financial panics in East Asia in 1998--sees investors as
a group suddenly and not very rationally become convinced that their
investments have become overly risky. As a result, they try to exchange their
investments for high-quality bonds and cash. But as everyone tries to do this at
once, they create the risk that they hoped to avoid: stock and real estate prices
crash, and interest rates spike upward as everyone tries to increase their holdings
of relatively safe, liquid assets.
In such a situation a central bank can do a lot of good very easily by rapidly
expanding the money supply, so that the increase in the demand for liquid assets
to hold doesn't lead to a spike in interest rates and a crash in other asset prices.
The problem is that a central bank can also do a lot of harm if it bails out those
institutions that have gone bankrupt and thus encourages others in the future to
take excessive risks hoping that the central bank will in its turn bail out them in
the future.
Thus the central bank has to (a) expand the money supply and lend freely to
institutions that are merely illiquid--that is, caught short of cash but
fundamentally sound--while (b) forcibly liquidating institutions that are
insolvent, those that could never repay what they owe even if the panic were
stemmed immediately. This is a neat trick--to do one without doing the other.
The most recent major financial crisis in the United States, the Great Depression,
was also the most destructive. Banks closed; at the beginning of 1933, more than
one in three of the banks that had existed in 1929 had closed its doors. When
banks failed, people who had their money in them were out of luck; years might
pass before any portion of their deposits would be returned. Hence fear of bank
failure leads to an immediate increase in households' and businesses' holdings of
currency relative to deposits. In the Great Depression this flight from banks
reduced the money supply.
One of the reforms of President Franklin D. Roosevelt's New Deal program in the
1930s was the institution of deposit insurance provided by the Federal Deposit
Insurance Corporation—the FDIC. If your bank failed, the government would
make sure your deposits did not disappear. The aim was to diminish monetary
instability by eliminating bank failure-driven swings in the money supply and
interest rates. Since the 1930s, federal deposit insurance acts as a monetary
automatic stabilizer. A financial panic gathers force when investors conclude that
they need to pull their money out of banks and mutual funds because such
investments are too risky. Deposit insurance eliminates the risk of keeping your
money in a bank--even if the bank goes belly-up, your deposit is still secure.
Thus, there is no reason to seek to move your money to any safer place. Deposit
insurance has broken one of the important links in the chain of transmission that
used to make financial panics so severe.
11. Monetary Policy
1. Why is monetary policy the most important tool used to try to stabilize the
economy today?
2. What lags complicate the use of monetary policy to stabilize the economy?
3. What is a recognition lag?
4. What is a formulation lag?
5. What is an implementation lag? Why is the implementation lag for monetary
policy so long?
6. Why are central banks tempted to run more expansionary monetary policies?
7. How do central banks try to maintain the credibility of their commitment to
low inflation?
8. Why might deposit insurance make the conduct of monetary policy easier?
9. How much ability does the Federal Reserve have to fight a typical recession
that is over less than eighteen months after it begins?
Answers to Self-Testing Questions
Topic 10
1. Monetary policy is faster and more reliable than discretionary fiscal policy.
The "best case" time for discretionary fiscal policy to affect the economy is
perhaps 20 months; the "worst case" time lag is as much as 48 months. For
monetary policy, the "best case" time is 15 months and the worst case time is only
24 months. Because monetary policy is faster to act than fiscal policy, it has a
very important edge as a stabilization policy tool.
2. There are three lags: recognition lags, formulation lags, and implementation
lags. The Federal Reserve has to recognize that there is need for action. It has to
formulate the policy. And it has to implement the policy and then wait for the
economic changes it has set in motion to have their full effects.
3. A recognition lag is the time it takes the FOMC to recognize that action is
required. Because the flow of data to the FOMC today is largely data about
events of two or so months ago, it can take a considerable time to recognize that
there truly is a problem.
4. The formulation lag is the time that it takes the FOMC to reach a consensus on
what to do. Because the FOMC is a committee that works by consensus, it may
take a while for it to formulate policy: members who have gone out on limbs
need to be given time and opportunities to climb down from them.
5. The implementation lag is the longest of the lags in the use of monetary policy.
It takes about a year or perhaps more for changes triggered by open market
operations to have their full effect on production and employment. When the
Federal Reserve acts, the interest rate falls today. But how long does it take
investment to respond to the fall in interest rates? And how long for the change
in investment to work its way through the multiplier? Even a Federal Reserve
that recognizes trouble quickly and formulates policy smoothly is still looking at
a lag of a year or more between when it takes action and when its actions have
their full effects.
6. The short-run effects of more expansionary monetary policy--reduced interest
rates, higher investment, higher employment, faster productivity growth--are all
positive and beneficial. In the short run there is little effect of expansionary
monetary policy on inflation. Thus, there is always the temptation to deviate
from the plan for a little while, and then attempt to restore one's credibility by
undoing the expansionary move.
7. The most important way to maintain credibility as an inflation fighter is for a
central bank to succeed at keeping inflation always low. The second most
important way is to reassure investors and others that the central bank does not
even think about adopting a more expansionary, higher-inflation monetary
policy.
8. Deposit insurance tends to make the money supply much more stable. By
eliminating the possibility that shocks to confidence in the financial system will
induce people to pull their money out of banks and so shrink the the money
stock, deposit insurance makes it easier for the central bank to stabilize the
economy.
Of course, deposit insurance creates other problems of its own, as we saw in the
1980s savings-and-loan crisis. . .
9. Not much. A typical recession develops suddenly and is over in 20 months.
Add up the recognition, formulation, and implementation lags, and you'll see
that monetary policy cannot react to a typical recession until it is almost over.